An A to Z of Economics: Part 2 – by Niall Kishtainy

Welcome to part two of Niall Kishtainy’s A-Z of Economics. Compiled exclusively for the Yale Books Blog to celebrate the publication of A Little History of Economics, Kishtainy’s A-Z brings to light the stories behind key economic terminology. Read on for M-Z, and if you missed A-L, you can read it here.

Illustrations by Hazel Partridge

Market Failure

Suppose that a paint factory releases into a river a chemical by-product that kills salmon in a nearby fishery. From society’s view, the paint factory produces too much paint because it doesn’t take into account of the impact of pollution. Economists recommend all sorts of policies to correct market failureslike this. The authorities could put a tax on pollution to encourage the factory to produce less, for example. Markets also fail when people have poor information about what they’re buying and selling. This happened in the run up to the global financial crisis when banks were trading in complicated financial products that they didn’t fully understand. In this case, a serious market failure damaged the health of the entire economy and it cast doubt on the effectiveness of Adam Smith’s invisible hand.

Neoclassical Economics

Neoclassical economics emerged in the late 19th century and has formed the template for the subject ever since. The earlier classical economists, such as Adam Smith and David Ricardo, hailed markets as the route to prosperity. Broad classes of people powered markets: workers, capitalists and landlords. The neoclassical economists instead viewed markets as simply the buying and selling of millions of individuals, individuals who were assumed ‘rational’ in the sense that they made decisions in a consistent, logical way. Today, economists base their theories of the economy as a whole on the behaviour of individuals.

Opportunity Cost

To an economist, cost is more than simply a certain amount of pounds and dollars. The opportunity cost of going to the cinema is the best alternative you give up, going out for a meal, perhaps. What, then, is the cost to society of building a new hospital? You could try to add up the cost of the bricks, cement and steel that went into it. The more fundamental opportunity cost is the best alternative use for those resources – building a new train station, perhaps. Opportunity cost highlights the fact that societies always face trade-offs and choices.

The Paradox of Thrift

Being thrifty and saving for a rainy day is often considered a virtue. John Maynard Keynes argued that saving could actually be self-defeating. ‘Whenever you save five shillings, you put a man out of work for a day,’ he said. The reason is that incomes depend on other’s spending. When we save more, we spend less. The consequence is that firms aren’t able to sell as much and have to sack workers. Unemployed workers have no money to save and as the total income of the economy plunges there’s less available overall to save than before. The paradox is that when we all try to save more we end up with a lower level of savings. Too much saving and too little spending means the economy is then in danger of stalling.

The Quantity Theory of Money

The quantity theory of moneyis an old theory that was revived in the 20th century by Milton Friedman. It says that if the government prints more money then prices go up faster. In the 1960s and 70s inflation in many leading economies began creeping up. Friedman said that this was because governments had become addicted to trying to boost their economies by creating too much money and going on spending sprees. Governments should instead commit to a steady growth in the money supply – 2 or 3 percent a year – in line with the growth of their economies. Friedman even suggested closing down central banks and replacing them with robots which would spew out money at the correct rate!

Rational Expectations

We try to predict the future all the time. How long will it take to get to the airport? What will my Apple shares be worth in a year? Rational expectations is the idea that people use all information available to make the most accurate prediction possible. For example, when deciding when to leave the house I’d take into account of new road works on the way to the airport. When investors have rational expectations it’s impossible to predict movements in share prices because prices reflect all the available information in the market. Rational expectations are an important part of economists’ toolkit. The theory has come in for a lot of criticism, though, for being a rather unrealistic depiction of actual economic decision making.

Surplus Value

Karl Marx believed that the value of a shirt is the amount of labour that went into it. Suppose that after five hours of stitching, a worker makes enough shirts to earn the minimum needed for survival. If her shift is twelve hours long then she makes seven hours’ worth of shirts above that minimum amount that she’s paid. Marx called the money from selling the extra shirts surplus value and it goes to the capitalist as profit. Marx said that capitalists squeeze out as much surplus value as possible by making their workers work long and hard hours. Today, economists have little use for the concept of surplus value: for them a shirt’s value isn’t its labour content but simply the price that emerges from market demand and supply.

Time Inconsistency

Teachers threaten students with detention if they’re lazy, but when students don’t do their homework, the teachers let them off because they hate giving out punishments. Knowing this, students don’t study and end up failing their exams. This is the problem of time inconsistency – making a commitment that everyone knows will be broken. Economists argue that governments face the problem when managing the economy. For example, after promising to keep inflation low, perhaps in the run up to an election, governments will be tempted to try to boost the economy, which ends up pushing up inflation.

Utility Maximisation

Conventional economics assumes that people make decisions to maximise their well-being or utility. In the 19th century it was thought that utilities could be measured and compared, like the temperature of liquids. One economist even imagined building a ‘hedonimeter’, a machine that would be able to say exactly how much utility someone gained from a bowl of cherries compared to a bunch of daffodils. Nowadays economists think of utility in a more abstract way. When people maximise utility they’re deciding what to do in a logical and consistent way – they’re being rational. The new field of behavioural economics has found that in reality there are all sorts of quirks in people’s decision making, which means that they’re not always as strictly rational as economists often assume them to be.

Voluntary Unemployment

In the 1980s when millions in Britain were unemployed, the British politician Norman Tebbit advised people to ‘get on their bikes’ and look for work. There were jobs to be had if people looked for them. Tebbit’s advice echoes an important idea about unemployment: that it’s largely voluntary rather than involuntary. Economists who make this claim believe that the labour market adjusts to eliminate unemployment: wages fall encouraging employers to take on more staff. Unemployed workers are out of work because they refuse to accept jobs at low enough wages. These economists stress the need for labour markets to be free and flexible. Those who say that unemployment is involuntary take their inspiration from Keynes who argued that unemployment is caused when there’s too little spending in the economy and there simply aren’t enough jobs.

Welfare Economics

How does an increase in petrol taxes or a reduction in health spending affect society’s overall well-being? The field of welfare economics deals with these sorts of questions. Its favourite criterion, pareto efficiency, says that a change is desirable if it benefits at least one person without hurting anyone. This ensures that resources aren’t squandered: it would be a waste for you not to receive a bunch of grapes that you’d enjoy but that everyone else was indifferent to. It’s sometimes claimed that free markets bring about pareto efficiency. Even if they do, we might still consider them unfair especially when they create a big gap between the rich and the poor.

X-inefficiency

Standard economics assumes that businesses produce using the minimum possible amount of inputs – tools, raw materials and workers. When they do there’s no slack in the system: there are no employees sitting around with nothing to do and no useful machines turning to rust. In fact, firms often operate with a lot of slack. Economists sum up the reasons in the term X-inefficiency. One is a lack of competition: when a firm has a monopoly or is protected from foreign competition then it might feel less pressure to use its inputs efficiently. More generally, people often make decisions according to habit and custom rather than the strict bottom line. An example of X-inefficiency was that of two Ford car plants which had the same design and equipment, one located in Germany and one in Britain. In the 1980s the German plant produced 50 percent more cars using 22 percent less labour compared to the British one.

Yield Curve

Governments and firms borrow money from the public by selling bonds, financial securities that pay interest to whoever owns them. Bonds mature after a certain number of years at which point the original loan is repaid. The yield curveshows the relationship between bonds’ rate of interest or yield and their maturity. Usually the curve slopes upwards: it’s riskier to lend money for twenty years than for five so bonds of a longer maturity generally pay a higher rate of interest. Sometimes the yield curve slopes downwards: this can be a sign that the economy is about to enter a recession.

Zero-sum Game

A zero-sum game is a situation like arm wrestling in which my gain is your loss. Centuries ago, economic thinkers thought that international trade was zero sum: there was a fixed amount of it to go round and if Britain exported more cloth to France then Britain gained and France lost. But in the 19th century the economist David Ricardo argued that when nations trade with each other then all of them gain. Recently, President Trump has revived the older zero-sum view of trade, counter to the outlook of most economists who largely share Ricardo’s optimism about the potential for trade to enrich all nations.

A Little History of Economics is available to preorder here. For more information on our Little Histories series, please visit the website. Follow Niall on Twitter @NiallKishtainy.